Interest Deductibility and Capital Structure The use of debt has a distinct advantage over financing with stock,

Interest Deductibility and Capital Structure The use of debt has a distinct advantage over financing with stock,

thanks to Congress. The Internal Revenue Code (IRC), written by Con- gress, allows interest paid on debt to be deducted by the paying corpo- ration in determining its taxable income. 4

This deduction represents a form of a government subsidy of financ- ing activities. By allowing interest to be deducted from taxable income, the government is sharing the firm’s cost of debt. To see how this sub- sidy works, compare two firms: Firm U (unlevered) and Firm L (levered). Suppose both have the same $5,000 taxable income before interest and taxes. Firm U is financed entirely with equity, whereas Firm L is financed with $10,000 debt that requires an annual payment of 10% interest. If the tax rate for both firms is 30%, the tax payable and net income to owners are calculated as follows:

Firm L (No Debt) ($10,000 Debt)

Firm U

$5,000 Less: interest expense

Taxable income before taxes and interest

0 1,000 Taxable income before taxes

$4,000 Less: taxes at 30% of taxable income

1,200 Net income to owners

$2,800 By financing its activities with debt, paying interest of $1,000, Firm

L reduces its tax bill by $300. Firm L’s creditors receive $1,000 of income, the government receives $1,200 of income, and the owners receive $2,800. The $300 represents money Firm L does not pay because they are allowed to deduct the $1,000 interest. This reduction in the tax bill is a type of subsidy.

4 Internal Revenue Code (IRC) (1986 Code) Section 163. For individuals, the interest deduction may be subject to limitations [IRC Section 163 (d)].

Capital Structure

If Firm LL (Lots of Leverage) has the same operating earnings and tax rate as Firms U and L, but uses $20,000 of debt (at the 10% interest rate), the taxes payable and net income to owners are as follows:

Firm LL (No Debt) ($10,000 Debt) ($20,000 Debt)

Firm U

Firm L

Taxable income before taxes and interest

$5,000 Less: interest expense

2,000 Taxable income before taxes

$3,000 Less: taxes at 30%

900 Net income to owners

$2,100 Comparing Firm LL to Firm L, we see that creditors’ income (the

interest expense) is $2,000 ($1,000 more than Firm L), taxes are $900 ($300 lower than Firm L’s $1,200 taxes) and the net income to owners $2,100 ($700 lower than Firm L’s net income). If Firm L were to increase its debt financing from $10,000 to $20,000, like Firm LL’s, the total net income to the suppliers of capital—the creditors and owners— is increased $300, from $3,800 to $4,100, determined as follows:

Firm L

Firm LL

($10,000 Debt) ($20,000 Debt)

Income to creditors

Income to owners

The distribution of incomes for Firms U, L, and LL is shown in Exhibit 18.6. In the case of Firm U, 70% of the income goes to owners and 30% goes to the government in the form of taxes. In the case of Firm LL, 42% of the income goes to owners and 18% goes to taxes, with the remaining 40% going to creditors.

Extending this example to different levels of debt financing, a pattern emerges. A summary of the distribution of income to creditors and share- holders (as well as the government’s share) for different levels of debt financing is shown in Exhibit 18.7. We are assuming, for simplicity, that the cost of debt (10%) remains the same for all levels of debt financing. And this would be the case in a perfect market. The government subsidy for debt financing grows as the level of debt financing grows. With increases in the use of debt financing, the creditors’ share of earnings increases and the owners’ and the government’s shares decrease.

FINANCING DECISIONS

EXHIBIT 18.6 Distribution of Income Among Owners, Creditors, and the

Government for Firms U, L and LL

EXHIBIT 18.7 Distribution of Income between Owners, Creditors, and the

Government for Different Levels of Debt Financing, Using a 30% Tax Rate and Assuming 10% Interest on Debt